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COMMERCIAL REAL ESTATE CLOS: FEATURES THAT MAKE THEM AN ATTRACTIVE ASSET CLASS FALL 2014

Commercial Real Estate CLOs: Features That Make Them an Attractive Asset Class

KIMBERLY E. DIAMOND

KIMBERLY E. DIAMOND

is a counsel in the specialty finance and lending and financial services practice groups at Lowenstein San- dler LLP in New York, NY.

kdiamond@lowenstein.com B

y definition, a hybrid is something that is formed by combining two things of different kinds. A hybrid that contains the most favorable traits of its parents without the parents’ down- falls is something that is generally desirable. In the structured finance and securitization context, a new hybrid asset class known as commercial real estate (CRE) collateralized loan obligations (CLOs) is such a hybrid. A CRE CLO manifests the most advantageous characteristics of its progenitors—the com- mercial mortgage-backed securities (CMBS) securitization transaction and the standard CLO transaction—from both a structural and collateral perspective. Moreover, CRE CLOs have adapted and independently evolved to accommodate the current landscape in terms

• f both providing a more resilient structure

that is attractive from a regulatory com- pliance perspective and offering investors a new product that offers more yield than

• ther structured products. For these reasons,

the features of a CRE CLO may be attrac- tive from an investor’s perspective and may also provide a private debt fund or mortgage REIT (real estate investment trust) with the

• pportunity to become involved as a collat-

eral originator, a collateral manager, and an investor with respect to this segment of the market. CURRENT LANDSCAPE FOR CMBS LOAN ORIGINATIONS In a CMBS securitization transaction, CRE mortgage loans are pooled and serve as the underlying transaction assets.1 Debt secu- rities collateralized by these assets are then issued from a trust created solely for that par- ticular transaction. In 2007, at the height of the market, the U.S. CMBS market saw more than $200 billion of CMBS issuance.2 The issuance amount fell to approximately $3 bil- lion in 2009 and has been steadily increasing

• ver the last four years, with $86 billion in

new CMBS issuance during 2013 and more than approximately $20 billion in issuance during first quarter 2014 (see Heschmeyer [2012], citing statistics from the Pension Real Estate Association; see also, SL Capital [2014a]). The CMBS market, consequently, appears to be making a slow and steady comeback. One reason for this stable growth in CMBS issuance is because lenders are being more cautious than they were in 2007 and in years prior with respect to the type of product that they are buying. Lending guidelines and underwriting standards with respect to the commercial mortgage loans that are being financed are much more conservative than they were in 2007 and earlier. Prudence

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and increased due diligence prevails in the marketplace now, as lenders are more thoroughly scrutinizing the geographical markets in which commercial real estate properties are located before making loans on such prop- erties (McIntyre [2014]). Also, lenders are more closely examining data, such as average rents from the markets in which these properties are located, before approving loans on such properties (McIntyre [2014]). It is poten- tially this heightened scrutiny and lender cautiousness that has caused there to be a historically low supply of commercial real estate loans at this juncture. GETTING OVER THE CMBS MATURITY WAVE/MATURITY WALL The commercial mortgage “maturity wave” or “maturity wall,” also called CMBS refinancing risk or balloon risk (Sober Look [2009]), refers to the more than $1 trillion in CRE mortgage loans constituting the underlying collateral in CMBS securitizations of vintages from 5 to 10 years ago that are going to be coming due in 2015–2017 (the legacy maturities) (SL Capital [2014b]). Specifically, a number of CRE mortgage loans in these securitizations have anticipated repayment dates (ARD loans) that will occur in the next three years. An ARD loan is unlike a typical balloon CRE loan insofar as non- repayment of the balance of an ARD loan will not con- stitute an event of default; rather, the borrower will be forced to have a higher interest rate and higher principal payments to accelerate the loan’s amortization (see Sober Look [2009]). Moreover, a significant and substantially large number of non-ARD loans, or standard balloon loans, also have maturity dates during the next three

• years. At maturity for a standard CRE balloon loan,

there are two options if payment cannot be made: 1) refinance the CRE mortgage loan or 2) sell the commer- cial real estate property to which such loan is tied (Sober Look [2009]). It is estimated that the legacy maturi- ties will take time to work out, while simultaneously exerting downward pressure on certain U.S. commercial property markets (Sober Look [2012]). The good news is that declining delinquency rates and a steady rise in CMBS issuance are evidence that the capital markets are better positioned currently than in years past to handle these legacy maturities (Gordon [2013]). According to a semi-annual forecast from Ernst and Young and the Urban Land Institute, the amount of CMBS issuance is predicted to continue to climb as a result of these legacy maturities, with CMBS issuance expected to increase to $100 billion in 2015 (Borchersen-Keto [2013]). The bad news, however, is that approximately one-third of these legacy maturities that are CRE balloon loans will be looking for shorter-term financing so that they can be refinanced into a more stabilized product. To do this successfully, borrowers will need access to capital. Refi- nancing these loans into new financing structures, such as CRE CLOs, will present appealing opportunities for

• lenders. As further discussed in the following section,

an attractive option for legacy maturity CRE mortgage loans is to refinance into either a combination of senior and mezzanine debt or to refinance into floating rate debt that is shorter-term in nature than typical CRE loans—something a CRE CLO offers. Thereafter, with such an option, the ultimate take-out is in the form of a fixed-rate loan used to collateralize a CMBS transac- tion, an insurance company loan, or a bank balance sheet financing. WHAT IS UNIQUE ABOUT CRE CLO TRANSACTIONS AND WHY USE THEM Structural Attractiveness As noted earlier, a CRE CLO is a hybrid between a CMBS securitization transaction and a CLO transaction. There are a number of structural features that make a CRE CLO enticing. First, the underlying collateral is appealing. The constitution of today’s CRE CLO collateral is quite dif- ferent from the collateral underlying CMBS transac- tions and pre-financial crisis CRE collateralized debt

• bligation (CDO) transactions. CMBS transactions of

2007 and earlier vintages often possessed “split loans”

• r “companion loans,” wherein a piece of a very large

CRE mortgage whole loan, which generally was one

• f the top 10 largest mortgage loans in the collateral

pool for a particular transaction, was split into a number

• f different pieces, some or all of which were placed

into other separate CMBS transactions. For instance, in a large CRE mortgage loan that is split into five pieces, the original CRE mortgage whole loan piece could be placed in one CMBS transaction while its four

• ther companion loans could be placed into four other

CMBS transactions. Notably, CMBS securitizations have a REMIC/static trust structure,3 which means that assets in the collateral pool cannot be substituted. As a

COMMERCIAL REAL ESTATE CLOS: FEATURES THAT MAKE THEM AN ATTRACTIVE ASSET CLASS FALL 2014

result, due to the static trust structure of CMBS transac- tions, large CRE mortgage whole loans and their split loan counterparts could not be pulled and substituted

• ut of the collateral pool for any of the transactions in

which the whole loan or its companion loan counter- parts were placed. From a concentration-risk perspec- tive, the CMBS transaction in which the CRE mortgage whole loan was placed was subject to less risk if there was a default on such whole loan, as the size of the piece

• f such whole loan serving as the underlying collateral

in that transaction was less than the size of the overall whole loan itself. However, a default on such whole loan resulted in cross-defaults across each CMBS transaction in which its companion loan counterparts were placed, subjecting certain tranches of issued securities in each such transaction to the risk of non-payment. There- fore one poorly performing, very large CRE mortgage whole loan could cause repercussions for multiple CMBS transactions and multiple classes of securities. Similarly, CRE CDOs of the CLO 1.04 era contained substantial high-risk underlying loan-pool collateral, such as mez- zanine loans and B-pieces.5 In contrast, today’s CRE CLOs from the CLO 2.0 era are distinguished from those from the CLO 1.0 era by improved collateral quality. No longer do mezzanine loans or B-pieces appear as underlying collateral. Rather, the collateral in a CRE CLO now consists of only CRE senior mortgage whole loans. These whole loans typi- cally have much shorter durations than CRE whole loans from CLO 1.0 vintages, with terms of approxi- mately 3–5 years rather than historically typical terms of approximately 10 years. This is because the underlying collateral in a CRE CLO consists of transitional assets that are not looking for long-term financing. Rather, these CRE mortgage loans are ones seeking short-term financing to re-position the property tied to the loan and create value or to refinance the loan. Consequently, CRE CLOs present the opportunity for private debt funds or mortgage REITs to 1) originate these refinanced CRE mortgage loans, 2) manage the CRE CLO’s collateral pool, and 3) access the capital markets by issuing bonds through such CRE CLO’s structure. Second, CRE CLOs are attractive due the option

• f having a reinvestment period feature as part of their
• structure. As noted earlier, unlike the collateral under-

lying a CMBS transaction, the loans constituting the underlying collateral in CRE CLOs do not have prepay- ment lock-outs. The downside of this structural feature is that the absence of these lock-outs allow for prepayments to be made on the underlying CLO collateral, which could ultimately cause the CLO transaction to become de-levered over time. The reinvestment period feature of a CLO potentially outweighs this non-lock-out feature. Because of its hybrid structure between that of a CLO and that of a CMBS transaction, a CRE CLO can have certain CLO structural features such as a ramp-up period, a reinvestment period, overcollateralization (OC) tests, and interest coverage (IC) tests. A reinvestment period feature enables the collateral manager to mitigate loan- prepayment risk. Also, during the reinvestment period (which in the CLO 2.0 era is approximately two years or more after the CLO’s closing date, as compared with the approximately five-year reinvestment period in CLOs from the CLO 1.0 era) and even thereafter, the collateral manager has discretion to substitute a fixed amount of existing underlying collateral with “new” or “substitute” collateral that satisfies certain criteria—including but not limited to the satisfaction of the CLO’s various par value tests and IC tests, as well as various collateral quality tests—to qualify as eligible collateral to be included in the loan pool. Having substitution rights allows the collateral manager to actively manage the underlying collateral, making decisions about the performance of individual loans, eliminating sub-performing collat- eral, and replacing it with new collateral. This, in turn, enhances the performance of the overall collateral pool. Such an active management feature is particularly attrac- tive and not present in a typical CMBS securitization structure, as discussed earlier. Third, CRE CLOs are structurally attractive from an investor’s perspective. Rating agencies have become familiar with and understand CRE CLO structures and, as a result, have the capacity to rate CRE CLO

• transactions. Being able to invest in ratable bonds may

be a compelling one for investors. Also, in a CMBS securitization structure, the sellers/sponsors of the CRE mortgage loans sell their respective loans in a true sale to the depositor entity. The depositor then deposits the commercial mortgage loans into the static trust, a common law trust formed on the securitization closing date, generally created by a pooling and servicing agree-

• ment. While there generally is a master servicer and

potentially a special servicer that carry out the adminis- trative function of servicing the mortgage loans, there is no transaction party who actively manages the portfolio and gets paid as part of the payment waterfall. A CRE

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CLO’s structure is different. In a CRE CLO, in addition to having a servicer, there is a collateral manager that actively manages the portfolio and often retains the sub-

• rdinated risk. Also, unlike the payment waterfall in a

CMBS securitization structure, a CLO can be structured such that the collateral manager is paid a senior collateral management fee near the top of the interest payments waterfall, prior to the payment of the senior-most notes in the capital stack, and is paid a subordinated collateral management fee as well at the bottom of this waterfall as an incentive for good collateral management. The subordinated collateral management fee is generally cal- culated by taking a fixed percentage rate per annum of the aggregate principal balance of the underlying col- lateral debt obligations and other assets constituting the collateral portfolio. The incentive collateral manage- ment fee is generally based on the aggregate distributions made on the subordinated notes issued as part of the CLO’s capital stack equaling or exceeding the original aggregate principal amount of such subordinated notes. This means that the collateral manager not only receives an up-front payment but also has the opportunity to be paid additional fees if all of the note holders in each tranche of the capital structure receive payments on each payment date. Accordingly, the collateral manager has a vested interest in the entire deal performing well, so that the collateral manager can get paid both at the top and bottom of the capital structure. For a non-bank investor in the broader invest- ment community, this CLO structure bodes well from a relative-value perspective. Investors are looking to maximize their yield, which they can do by investing in a tranche lower in the capital stack. In a securitization transaction, the lower the tranche in which one invests in the capital stack, the greater return one may receive, but the greater risk one runs of not getting paid. Investors in tranches not at the top of the capital stack therefore have to consider their risk–return proposition (e.g., the amount of risk they are willing to take, compared with the potential amount of return they can make on their investment). In contrast, in a CRE CLO, because the collateral manager has “skin in the game” tied to the CLO’s overall performance, the risk of not getting paid if

• ne invests in a tranche lower in the capital stack poten-

tially may not be as great as it would be if one invested in a CMBS securitization transaction. The structure of a CRE CLO therefore offers investors more yield than a securitization structure and allows investors access to yield in a yield-deficient environment, with a better alignment of interests between the investor and the col- lateral manager as the entity sourcing the collateral. Regulatory Attractiveness The hybrid structure of a CRE CLO provides reg- ulatory attractiveness insofar as such structure enables a CRE CLO to qualify under an Investment Company Act of 1940 exemption that allows it to escape treat- ment as a “covered fund” under the Volcker Rule. As background, in July 2010, Section 619 of the Dodd– Frank Wall Street Reform and Consumer Protection Act amended the Bank Holding Company Act of 1956 (the BHC Act)6 to include a new Section 13 as its end.7 This new section of the BHC Act, “Prohibitions on Pro- prietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds,” is commonly known as the Volcker Rule. Under the Volcker Rule, banks are prohibited from acquiring or retaining an equity, partnership, or other ownership interest in, or being a sponsor of, a hedge fund or private equity fund. This restriction on banks’ ability to make risky investments is known as the “covered funds” provision of the Volcker Rule.8 Under the Volcker Rule, the terms hedge fund and private equity fund, which are each covered funds, are each defined as “an issuer that would be an invest- ment company, as defined in the Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.), but for section 3(c) (1) or 3(c)(7) of that Act.”9 As the implementing regu- lations for the Volcker Rule explain,10 a covered fund may rely on these two “private” Investment Company Act exemptions only if such fund is not engaged in the type of investment activities contemplated by the Vol- cker Rule. Section 3(c)(7) of the Investment Company Act excludes from the definition of investment company funds that are owned exclusively by qualified purchasers. This “qualified purchasers” exemption is the Investment Company Act exemption that most CLOs use. Conse- quently, in a CRE CLO, having a static or quasi-static pool structure will enable the fund to qualify under this exemption and not be treated as a covered fund. Also, the Volcker Implementing Regulations clarify that, based on Section 13(g)(2) of the Volcker Rule,11 the securitization of loans is specifically carved

• ut from coverage under the Volcker Rule.12 Notably,

Section 3(c)(5)(C) of the Investment Company Act pro- vides an exemption for persons “purchasing or otherwise

COMMERCIAL REAL ESTATE CLOS: FEATURES THAT MAKE THEM AN ATTRACTIVE ASSET CLASS FALL 2014

acquiring mortgages and other liens on and interests in real estate.”13 Because of its hybrid securitization/CLO structure, and because a CRE CLO is backed by CRE mortgage loans as its underlying assets, a CRE CLO can use the Section 3(c)(5)(C) mortgage loan exemption, rather than the Section 3(c)(7) exemption, and will not be considered to be a covered fund under the Volcker

• Rule. This ability to clear the Volcker Rule may be a

particularly attractive and important feature for investors who invest in CLO products. CONCLUSION CRE CLOs, due to their hybrid structure, offer investors the benefits of having certain attributes of a CLO structure and of a CMBS securitization trans- action, along with their own unique characteristic of having senior CRE mortgage whole loans as underlying

• collateral. Because such collateral has a shorter term than

typical CLO or CMBS collateral, and because CRE CLOs generally contain an active management feature wherein the collateral manager monitors and can sub- stitute collateral, CRE CLOs offer collateral-quality attractiveness as well as attractiveness for investors who want to consider investing in securities in tranches other than the highest tranches in the capital stack. From a collateral manager’s perspective, the ability to attract a diverse investor base and avoid covered fund status under the Volcker rule, as well as to benefit from the priority

• f payments structure and ability to hold a deeply sub-
• rdinated tranche of the CLO, may be tempting reasons

to become involved with this asset class. Ultimately, understanding the distinctions between a CRE CLO and a CRE CDO or CMBS transaction and weighing the relative benefits of investing in CRE CLO product as compared with investing in other products is a cru- cial first step in evaluating the advantages a CRE CLO

• presents. For the reasons discussed here, taking this first

step in becoming more familiar with CRE CLOs as an asset class is a worthwhile endeavor for investors, private debt funds, and mortgage REITs alike. ENDNOTES

The information for this article generally was obtained from the panel, “The Role of CLOs in Financing Commercial Real Estate Finance,” held during the Third Annual Inves- tors’ Conference on CLOs and Leveraged Loans, on April 23, 2014, in which David Baranick of PricewaterhouseCoopers, Tim Groves of Citi, Avner Husen of Fortress, and Steven Kolyer of Clifford Chance U.S. LLP participated as faculty, as well as from the author of this article. Such information has been supplemented by the other sources noted.

1CRE mortgage loans that serve as the underlying col-

lateral in a CMBS transaction are generally fixed-rate loans that characteristically possess prepayment penalties (prepay- ments on the loan are permitted, but an additional penalty for prepayment is required), yield maintenance clauses (prepay- ments on the loan are permitted, but must have a prepayment penalty such that the yield to maturity is not affected), or lock-out provisions (prepayments on the loan are not per- mitted for a certain fixed term). See Levitin and Wachter [2013].

2See McIntyre [2014]. According to one source, the

2007 CMBS vintage was considered “the weakest in terms

• f underwriting standards” with analysts expecting many of

these loans to have difficulty paying their balances in full or securing refinancing upon their balloon maturity date. See Heschmeyer [2012].

3REMIC is the acronym for real estate mortgage invest-

ment conduit.

4Transactions from the CLO 1.0 era refer to those CLOs

issued prior to 2008. Transactions from the CLO 2.0 era refer to new issuance, post-financial-crisis CLOs.

5The “B-piece” in a CMBS transaction is the junior-

most subordinated tranche of the issued debt. As a tradeoff for owning this tranche, which bears the first loss credit risk, B-piece investors receive control rights with respect to the transaction that other investors in more senior tranches do not possess. See Levitin and Wachter [2013].

6For more information, see U.S. Code at http://

www.gpo.gov/fdsys/pkg/USCODE-2012-title12/html/ USCODE-2012-title12-chap32-sec3106.htm.

7For more information, see H.R. 4173-245.

Available online at http://thomas.loc.gov/cgi-bin/ bdquery/z?d111:H.R.4173:.

8See Richards [2014]. 9H.R. 4173-255, Section 13(h)(2) (“Definitions –

Hedge Fund; Private Equity Fund”); for more information, see http://thomas.loc.gov/cgi-bin/bdquery/z?d111:H.R.4173:.

10See the Volcker Implementing Regulations, Part

III.C., paragraph 1 (“Overview of Final Rule – Restrictions

• n Covered Fund Activities and Investments”); http://www.
• cc.gov/topics/capital-markets/financial-markets/trading/

volcker-rule-implementation/index-volcker-rule-implemen- tation.html.

11H.R. 4173-254, Section 13(g)(2) (“Rules of Con-

struction – Sale or Securitization of Loans”).

12See Volcker Implementing Regulations. The ratio-

nale provided for this carve-out is that the agencies involved

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in producing the Volcker Implementing Regulations (e.g., the Office of the Comptroller of the Currency, Treasury; the Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; and the Securities and Exchange Commission) believe that “most securitiza- tion transactions are currently structured so that the issuing entity with respect to the securitization is not an affiliate of a banking entity under the BHC Act.”

13Investment Company Act of 1940, Section 3(c)(5)(C).

REFERENCES Baranick, D., T. Groves, A. Husen, and S. Kolyer. “The Role

• f CLOs in Financing Commercial Real Estate Finance.”

Discussion panel at the Third Annual Investors’ Conference

• n CLOs and Leveraged Loans, April 23, 2014.

Borchersen-Keto, S. “CMBS Issuance on the Upturn as Loans Approach Maturity.” REIT.com, October 24, 2013. Avail- able at http://www.reit.com/news/articles/cmbs-issuance- upturn-loans-approach-maturity. Gordon, T. “Capital Markets Healing But Maturity Hurdle Remains.” Blog post, Auction.com, December 17, 2013. Available at http://auction.com/blog/capital-markets- healing-but-maturities-hurdle-remains/. Heschmeyer, M. “CMBS Class of 2007: The Smaller They Are, the Harder They Fall.” The Watch List, Costar.com, May 24, 2012. Available at http://www.costar.com/News/ Article/CMBS-Class-of-2007-The-Smaller-They-Are-The- Harder-They-Fall/138672. Levitin, A.J., and S.M. Wachter. “The Commercial Real Estate Bubble.” Harvard Business Law Review, Vol. 3, No. 91 (July 15, 2013). McIntyre, A. “5 Things Lawyers Need to Know About CMBS Post-Meltdown.” Law360.com, May 6, 2014. Richards, L. “The Volcker Rule Proposal and Asset Manage- ment Firms.” Asset Management Insights, PricewaterhouseCoo- pers LLP 2014. Available at http://www.pwc.com/gx/en/ asset-management/asset-management-insights/volcker-rule- proposal.jhtml. SL Capital. “CMBS Market Poised for More Growth in 2014.” CMBS Market Monitor, SL Capital LLC, 2014a. Available at http://www.slcapmarkets.com/announcement.php/. ——. “Maturing Loans Will Boost CMBS Activity in Coming Years.” CMBS Market Monitor, 2014b. Available at http://www.slcapmarkets.com/announcement.php/. Sober Look. “CMBS Balloon Risk Looming.” Available at http://soberlook.com/2009/08/cmbs-balloon-risk-looming. html, August 3, 2009. ——. “The CMBS Maturity Wall is Here.” Available at http://soberlook.com/2012/03/cmbs-maturity-wall-is-here. html, March 16, 2012. To order reprints of this article, please contact Dewey Palmieri at dpalmieri@iijournals.com or 212-224-3675.